GOLD OR THE DOLLAR: WHICH WILL BE STRONGER?

FINANCIAL MARKET ANALYSIS

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Investors are anticipating four rate cuts over the next 12 months in the United States. With the Fed's governors having recently reiterated their forward guidance, market participants are expecting a first rate cut in June or September, from 5.50% to 5.25%, followed by three more to reach 4.50% in March 2025 (see Fig. 2). This level of yield corresponds to that on bonds currently maturing in 5 to 10 years. Despite these expectations of lower rates, investors continue to favour very short-term fiduciary deposits. Proof of this is provided by the inflows into money market funds, which have just reached record levels (see Fig. 3).

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There are two disadvantages to keeping short-duration bonds in portfolios:

• In 6-, 12- or 18-months' time, when they have to roll over their positions, investors will not be able to obtain as good investment conditions as they do today. As interest rates fall, future yields (4.50%) will be significantly lower than current ones (5.50%).
• Historically, when the yield curve steepens, it does so in two distinct phases. First, the short end of the curve falls (bull steepening) and the curve tends to shift downwards. Thus, thanks to the positive effects of duration, long bonds deliver better returns. It is only in the second phase that long rates rise, completing the steepening process (bear steepening), and the price of long bonds suffers as a result.

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Given these two opportunity costs, investors will eventually extend the duration of their bond portfolios.

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Ironically, institutional investors in search of yield are accumulating an asset that delivers no coupon: gold. The precious metal has just hit record highs of $2,400 an ounce. After such a surge, a major technical retracement is highly likely, even if several factors militate in favour of a new bullish wave:

• Adjusted for inflation, gold has not yet reached its two previous record highs. To maintain its purchasing power of 2020, 2011 and 1979, it would have to trade at 2'500, 2'654 and 3'420 respectively in 2024 dollars (see Fig. 4).
• Unlike central banks and investment professionals, who have massively accumulated gold in recent quarters, private investors have not yet embraced this theme. Since peaking in October 2020, the volume of gold held by index funds (ETFs) has fallen by 26%. To catch up, private investors would need to buy some 70 million additional ounces of gold, an increase of 85% on the volume currently held (see Fig. 5).
• In the longer term, falling interest rates, geopolitical tensions, monetisation of debt, climate change and any other uncertainties that cause stress among investors will lead to a structural appreciation of the ultimate safe-haven asset.

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The decorrelation between the gold price and the dollar exchange rate raises questions (see Chart of the Week). Which of the two has rightly appreciated, and which will have to fall to close the gap?

• In a first scenario, gold would return to $1,900 an ounce.
• Alternatively, the dollar would trade at 1.20 per euro.
• In a third and final possibility, the gap may never be closed. This would mean that the relationship between the two 'currencies' has broken down, as happens regularly. Bear in mind that the long-term trend for gold is upwards, while the trend in the euro/dollar exchange rate is relatively stable.

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Conclusion:

For fundamental reasons, investors will seek to keep a significant share of gold in their portfolios. Their optimal strategic allocation requires a substantial weighting in this safe-haven asset. Beyond this 'core' portion, in their tactical allocation, they will secure part of the gains made through gold, or even sell dollars in anticipation of the greenback's depreciation.

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RETURN ON FINANCIAL ASSETS